Monday, February 16, 2009

Weekly Hurriyet Column: The curious case of government bonds

Below is the unedited version of my column for this week. You can read the final version at Hurriyet's authors archive. In retrospect, I might look like a fool after the huge Treasury rally after I wrote this column. But on second look, there isn't a much of a rally left once you leave out global effects (common to other EM) as well as factor in CBT cuts. In the same vein, with the global rally having slowed down at the end of April and the CBT having room for at most another 75bp cut, I find expectations of another 150bp fall in Treasuries somewhat out of whack...

Last week, the economics agenda was rather lively. While the policymaking community was doing its best to lighten up the mood with humorous words and deeds, it was also possible to detect some important signals pertaining to government bonds, most of which got almost lost in all the clatter.

Turkish Statistical Institute’s (TURKSTAT) industrial production data blunder was highly entertaining and managed, albeit unintentionally, to turn the attention away from the dismal figures, which have ascertained that the economy almost came to a halt in 2008, to the dismal Institute. That a 40% growth in textiles could go undetected would itself warrant a separate column, but having spent some time at TURKSTAT thanks to various World Bank projects, I somehow wasn’t surprised at all. Quoting Forrest Gump, stupid is as stupid does, and that's all I have to say about that.

Equally entertaining were Economics Minister Mehmet Simsek’s remarks that if the government had acted early on the crisis and secured an IMF deal, the recession would have been deeper. Never mind the contradiction with another claim made moments earlier that inflation and interest rates were falling thanks to the government’s measures, I find it hard to choose which part of the statement is more virtual: The implication that the government is acting now or that an IMF deal would have fuelled the recession.

While the former is simply out of sync with reality, the latter is based on the idea that the Fund would have called for tighter fiscal policy instead of the loosening necessary to get the economy out of recession. In fact, the January budget figures of last week have been justified in some circles on exactly these grounds. To me, the figures reek of election spending rather than a boost to the economy. Moreover, even in developed countries, where textbook expansionary policy works best, the effectiveness of fiscal stimulus is uncertain. In Turkey, where there is arguably much less scope for fiscal policy, it is remarkable that expansionary policy is taken as a panacea without question by many.

The demand and supply picture for bonds

Election spending or not, the rise in expenditures, along with the decrease in tax revenues on the back of a slowing economy, is causing a rapid deterioration in the budget. If not reversed, this trend is likely to lead to an increase in the debt rollover ratio, putting upward pressure on bond rates and crowding out private lending. In this sense, although the Treasury does not face a heavy financing burden for the next couple of months, the fiscal outlook does not paint a supportive supply picture for bonds.

Turning to the demand side, while I plan to wait until all the fourth quarter balance sheets are released before a complete assessment of the banking sector, early releases show that banks have indeed been banking on rate cuts, with gains from the bond rally making up for the contraction in interest margins and the stall in loans. However, the latest figures also reveal an upward trend in non-performing loans (NPLs). If NPLs are to surge to twice the 2008 figure of 3.5% by mid-year, as forecasted by some analysts, simple scenario analysis reveals that banks’ appetite for bonds could be severely hampered. Therefore, the demand for bonds does not look that rosy, either.

Lately, I am seeing a lot of bond-optimists, dancing to the tune of Central Bank and fiscal policy. However, neither bond fundamentals, which I outlined in previous columns, nor a supply-demand framework justifies such confidence. The question is not when the music will stop, but who will be left standing when it does.

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